krugman.blogs.nytimes.com
by Paul Krugman
by Paul Krugman
A number of
readers, both at this blog and other places, have been asking for an
explanation of what IS-LM is all about. Fair enough – this blogosphere
conversation has been an exchange among insiders, and probably a bit
baffling to normal human beings (which is why I have been labeling my
posts “wonkish”).
[Update: IS-LM stands for investment-savings, liquidity-money -- which will make a lot of sense if you keep reading]
So, the first thing you need to know
is that there are multiple correct ways of explaining IS-LM. That’s
because it’s a model of several interacting markets, and you can enter
from multiple directions, any one of which is a valid starting point.
My favorite of these approaches is to
think of IS-LM as a way to reconcile two seemingly incompatible views
about what determines interest rates. One view says that the interest
rate is determined by the supply of and demand for savings – the
“loanable funds” approach. The other says that the interest rate is
determined by the tradeoff between bonds, which pay interest, and money,
which doesn’t, but which you can use for transactions and therefore has
special value due to its liquidity – the “liquidity preference”
approach. (Yes, some money-like things pay interest, but normally not
as much as less liquid assets.)
How can both views be true? Because we
are at minimum talking about *two* variables, not one – GDP as well as
the interest rate. And the adjustment of GDP is what makes both loanable
funds and liquidity preference hold at the same time.
Start with the loanable funds side.
Suppose that desired savings and desired investment spending are
currently equal, and that something causes the interest rate to fall.
Must it rise back to its original level? Not necessarily. An excess of
desired investment over desired savings can lead to economic expansion,
which drives up income. And since some of the rise in income will be
saved – and assuming that investment demand doesn’t rise by as much – a
sufficiently large rise in GDP can restore equality between desired
savings and desired investment at the new interest rate.
That means that loanable funds doesn’t
determine the interest rate per se; it determines a set of possible
combinations of the interest rate and GDP, with lower rates
corresponding to higher GDP. And that’s the IS curve.
Meanwhile, people deciding how to
allocate their wealth are making tradeoffs between money and bonds.
There’s a downward-sloping demand for money – the higher the interest
rate, the more people will skimp on liquidity in favor of higher
returns. Suppose temporarily that the Fed holds the money supply fixed;
in that case the interest rate must be such as to match that demand to
the quantity of money. And the Fed can move the interest rate by
changing the money supply: increase the supply of money and the interest
rate must fall to induce people to hold a larger quantity.
Here too, however, GDP must be taken
into account: a higher level of GDP will mean more transactions, and
hence higher demand for money, other things equal. So higher GDP will
mean that the interest rate needed to match supply and demand for money
must rise. This means that like loanable funds, liquidity preference
doesn’t determine the interest rate per se; it defines a set of possible
combinations of the interest rate and GDP – the LM curve.
And that’s IS-LM:
The point where the curves cross
determines both GDP and the interest rate, and at that point both
loanable funds and liquidity preference are valid.
What use is this framework? First of
all, it helps you avoid fallacies like the notion that because savings
must equal investment, government spending cannot lead to a rise in
total spending – which right away puts us above the level of argument
that famous Chicago professors somehow find convincing. And it also gets
you past confusions like the notion that government deficits, by
driving up interest rates, can actually cause the economy to contract.
Most spectacularly, IS-LM turns out
to be very useful for thinking about extreme conditions like the
present, in which private demand has fallen so far that the economy
remains depressed even at a zero interest rate. In that case the picture
looks like this:
Why is the LM curve flat at zero?
Because if the interest rate fell below zero, people would just hold
cash instead of bonds. At the margin, then, money is just being held as a
store of value, and changes in the money supply have no effect. This
is, of course, the liquidity trap.
And IS-LM makes some predictions
about what happens in the liquidity trap. Budget deficits shift IS to
the right; in the liquidity trap that has no effect on the interest
rate. Increases in the money supply do nothing at all.
That’s why in early 2009, when the
WSJ, the Austrians, and the other usual suspects were screaming about
soaring rates and runaway inflation, those who understood IS-LM were
predicting that interest rates would stay low and that even a tripling
of the monetary base would not be inflationary. Events since then have,
as I see it, been a huge vindication for the IS-LM types – despite some
headline inflation driven by commodity prices – and a huge failure for
the soaring-rates-and-inflation crowd.
Yes, IS-LM simplifies things a lot,
and can’t be taken as the final word. But it has done what good economic
models are supposed to do: make sense of what we see, and make highly
useful predictions about what would happen in unusual circumstances.
Economists who understand IS-LM have done vastly better in tracking our
current crisis than people who don’t.
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